Depreciation is used by the IRS to show the value of commercial property lost over time due to wear, damage, obsolescence, and other forms of diminution. Most commercial property is depreciated over 39 years, but commercial residential property, such as a multifamily property, has a 27.5-year depreciation period. Value lost from depreciation can be used to shelter income from the property.
Recording depreciation is mandatory. Since land does not depreciate, when you purchase a plot of land with a building on it for investment purposes you must keep separate accounts of your land and buildings to track the depreciation of the latter. Your accounting should be based on costs—the money you initially paid (both the purchase price and the closing costs), as well as the cost of capital improvements, if you make any—rather than on value.
Cost and value may not be identical. Due to market forces, negotiations, or other factors, the cost of the property may differ significantly from its appraised value. The cost is divided proportionally between the land and items on the land that will be depreciated (buildings, sidewalks, infrastructure, etc.), all of which are referred to as “improvements,” based on an appraisal.
So, if you bought a plot of land with an apartment building on it at a cost of $1.5 million, and that property was appraised at $400,000 for the land and $600,000 for the improvements, you would divide your costs into two accounts to reflect the proportions revealed in the appraisal.
Let’s look at the math:
Cost of the property: $1,500,000
Cost of the land: $600,000 (40 percent of the total property cost)
Cost of the building: $900,000 (60 percent of the total, based on an appraisal)
Depreciation rate: 27.5 years (paid at a rate of 1/27.5 annually)
$900,000 / 27.5 = $32,727 (annual depreciation deduction)
To add more to this scenario, if you sold your property 17 years later, without having made capital improvements, you would have already deducted 17/27.5 of the cost of the building ($556,363—that is, $32,727 x 17) from your income taxes. But let’s say your property did not depreciate in market value but instead appreciated and sold for $3 million. Let’s take a look at what the depreciation recapture tax would look like if you sold the property and took the cash proceeds as opposed to completing a 1031 tax-deferred exchange.
The $556,363 in depreciation previously taken during the holding period is recaptured at sale and is taxed at a flat federal rate of 25%. Therefore, you would owe $139,091 (25 percent of $556,363) in depreciation recapture tax.
How the 1031 Exchange Can Help You Avoid Depreciation Recapture
A 1031 exchange allows you to exchange a property for a like-kind property and defer the taxes on the relinquished property. This works for depreciation recapture as well as for capital gains. Since depreciation begins as soon as a transaction is completed, depreciation recapture is a factor in every 1031 exchange.
Taxes are deferred in the exchange, not canceled, so the tax liability on the recapture amount rolls over to the new property and remains with the exchanger’s properties until the exchanger cashes out or passes away. If the exchanger cashes out, the accumulated depreciation recapture tax becomes due along with capital gains tax. If the exchanger passes away, depreciation recapture is wiped out along with the deceased’s capital gains tax, and only the estate tax is paid on the property if the estate is large enough to trigger it. If a developed property is exchanged for undeveloped land, depreciation recapture cannot be deferred.
There are a few complicating factors that can affect this procedure. For instance, an expert may advise you on the tax benefits of dividing your depreciation accounting more narrowly in a process known as cost segregation. In that case, a highly trained specialist can do an engineering-based segregation study, which may determine that some of the components of your investment property are personal property, which depreciates much faster, generally in five to 15 years.
When this occurs, the recategorized property is no longer subject to depreciation under the same rules. IRC Section 1245 is applied in place of IRC Section 1250. In a 1031 exchange, a relinquished property that includes Section 1245 items must be exchanged for a replacement property with an equal value amount of Section 1245 items. Property that began its service life before 1987 is also subject to somewhat different rules for depreciation recapture.
Depreciation recapture is complex and can overwhelm anyone without a high level of specialized training. It is strongly recommended that an investor seek professional advice on this subject when making a 1031 exchange or cashing out a property used in a 1031 exchange.
At CWS Capital Partners, we have decades of experience guiding investors through 1031 exchange transactions. Contact us today to learn more and to get started.
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